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- The current ratio measures a company's capacity to pay its short-term liabilities due in one year.
- The current ratio weighs a company's current assets against its current liabilities.
- A good current ratio is typically considered to be anywhere between 1.5 and 3.
When determining a company's solvency 一 the ability to pay its short-term obligations using its current assets 一 you can use several accounting ratios. The current ratio is one of them. The current ratio is a measure used to evaluate the overall financial health of a company. Here's how it works and how to calculate it.
What is the current ratio?
Definition and significance
The current ratio, sometimes referred to as the working capital ratio, is a metric used to measure a company's ability to pay its short-term liabilities, or those due within a year. In other words, it shows how a company can maximize current assets to settle its short-term obligations.
"The current ratio is simply current assets divided by current liabilities. A higher ratio indicates a higher level of liquidity," says Robert Johnson, a CFA and professor of finance at Creighton University Heider College of Business.
When you calculate a company's current ratio, the resulting number determines whether it's a good investment. A company with a current ratio of less than 1 has insufficient capital to meet its short-term debts because it has a larger proportion of liabilities relative to the value of its current assets.
On the other hand, a company with a current ratio greater than 1 will likely pay off its current liabilities since it has no short-term liquidity concerns. An excessively high current ratio, above 3, could indicate that the company can pay its existing debts three times. It could also be a sign that the company isn't effectively managing its funds.
The current ratio can help determine if a company would be a good investment. But since the current ratio changes over time, it may not be the best determining factor for which company is a good investment. This is because a company facing headwinds now could be working toward a healthy current ratio and vice versa.
Calculating the current ratio
Formula and components
The current ratio is calculated using two common variables found on a company's balance sheet: current assets and current liabilities. This is the formula:
The resulting figure represents the number of times a company can pay its current short-term obligations with its current assets.
Current assets
Current assets are all the assets listed on a company's balance sheet expected to be converted into cash, used, or exhausted within an operating cycle lasting one year. Current assets include cash and cash equivalents, marketable securities, inventory, accounts receivable, and prepaid expenses.
Current liabilities
Current liabilities are a company's short-term obligations due and payable in one year. Common current liabilities found on the balance sheet include short-term debt, accounts payable, dividends owed, accrued expenses, income taxes outstanding, and notes payable.
Current ratio example
Let's take a look at a real-life example of how to calculate the current ratio based on the balance sheet figures of Amazon for the fiscal year ending 2019. The current assets of the retail giant stood at $96.3 billion and current liabilities at $87.8 billion.
To calculate the current ratio, you divide the current assets by current liabilities. So the current ratio for Amazon will be 1.1, meaning the company has at least enough assets to pay off its short-term obligations.
How to interpret the current ratio
What different values indicate
Some companies in specific industries may have a current ratio below 1, while others may exceed 3. Food services and retail, for example, may be more likely than other industries to have companies that quickly collect revenue from customers but take far longer to reimburse their suppliers, which could result in them having a current ratio below 1.
"A good current ratio is really determined by industry type, but in most cases, a current ratio between 1.5 and 3 is acceptable," says Ben Richmond, US country manager at Xero. This means that the value of a company's assets is 1.5 to 3 times the amount of its current liabilities.
Note: A highly excessive current ratio typically above 3 doesn't necessarily mean a company is a good investment. It could mean that the company has problems managing its capital allocation effectively.
Another factor that may influence what constitutes a "good" current ratio is who is asking. While an investor may interpret a current ratio of 3 or higher as pointing to operational inefficiencies, a lender might look favorably upon such a ratio, considering it a strong signal that the company in question can pay its debts.
The role of the current ratio in financial analysis
Assessing company liquidity
The current ratio is one tool you can use to analyze a company and its financial state. An interested investor might also want to look at other key considerations like an organization's profit margins and quick ratio, for example.
The current ratio, in particular, is one way to evaluate a company's liquidity, specifically the ease with which they can cover their short-term obligations. However, it is not the only ratio an interested party can use to evaluate corporate liquidity.
Comparing with other liquidity ratios
Current ratio vs. quick ratio
Another ratio, which is similar to the current ratio and can be used as a liquidity measure, is the quick ratio. Both give a view of a company's ability to meet its current obligations should they become due, though they do so with different time frames in mind.
The current ratio evaluates a company's ability to pay its short-term liabilities with its current assets. The quick ratio measures a company's liquidity based only on assets that can be converted to cash within 90 days or less.
The key difference between the two liquidity ratios is that the quick ratio only considers assets that can be quickly converted into cash, while the current ratio takes into account assets that generally take more time to liquidate. In other words, "the quick ratio excludes inventory in its calculation, unlike the current ratio," says Johnson.
Current ratio vs. cash ratio
Another ratio interested parties can use to evaluate a company's liquidity is the cash ratio. The cash ratio is like the current ratio, except it only considers a company's most liquid assets in evaluating its liquidity.
More specifically, the current ratio is calculated by taking a company's cash and marketable securities and then dividing this value by the organization's liabilities. This approach is considered more conservative than other similar measures like the current ratio and the quick ratio.
Factors influencing the current ratio
Variability in asset composition
Potential investors leveraging the current ratio should keep in mind that the assets of companies can vary quite a bit, and businesses with significantly different asset compositions can end up with the same current ratio.
For example, a company's inventory, which can prove difficult to liquidate, could account for a substantial fraction of its assets. Since this inventory, which could be highly illiquid, counts just as much toward a company's assets as its cash, the current ratio for a company with significant inventory can be misleading.
Seasonal and industry impacts
Businesses may experience fluctuations in their current ratio as a result of seasonal changes. For example, a retail business may have a higher level of inventory during the holiday season, which could impact its ratio of assets to liabilities. Further, a company may need to borrow more during slow seasons to fund its operations, which could also impact the current ratio.
Limitations of the current ratio
Potential for misinterpretation
The current ratio has several limitations that could cause it to be misinterpreted. It is crucial to keep this in mind when using the current ratio for investment decisions. As noted earlier, variations in asset composition can cause the current ratio to be misleading.
Another consideration is differences between industries. The current ratio may not be particularly helpful in evaluating companies across different industries, but it might be a more effective tool in analyzing businesses within the same industry.
Some industries may collect revenue on a far more timely basis than others. Restaurants, for example, collect revenue from customers the day of. However, other industries might extend credit to customers and give them far more time to pay. If a company's accounts receivables have significant value, this could give the organization a higher current ratio, which could in turn prove misleading.
The need for contextual analysis
An investor looking to use the current ratio in evaluating a potential investment should keep in mind that the aforementioned ratio is just a starting point, and doing further research could be quite useful in gaining a more detailed, nuanced view of a business's financial health.
Being familiar with this consideration is crucial when it comes to interpreting current ratio values in finance.
Enhancing financial strategy with the current ratio
The current ratio measures a company's capacity to meet its current obligations, typically due in one year. This metric evaluates a company's overall financial health by dividing its current assets by current liabilities.
A current ratio of 1.5 to 3 is often considered good. However, when evaluating a company's liquidity, the current ratio alone doesn't determine whether it's a good investment or not. It's therefore important to consider other financial ratios in your analysis.
FAQs
How does the current ratio differ from the quick ratio?
The current ratio accounts for all of a company's assets, whereas the quick ratio only counts a company's most liquid assets.
What does a current ratio greater than 1 signify?
A current ratio above 1 signifies that a company has more assets than liabilities. It should at least be able to cover its liabilities in the short-term.
Can a very high current ratio be a bad sign?
A very high current ratio could mean that a company has substantial assets to cover its liabilities. However, it could also mean that a business is not using its resources effectively.
How can seasonal businesses interpret the current ratio?
Seasonal businesses can experience substantial fluctuations in their current ratio. This figure can be interpreted through the lens of where a company is in its operating cycle.
Why is it important to compare the current ratio within the same industry?
The current ratio can vary widely between industries, and companies within an industry follow certain patterns that can make the ratio a far more useful tool for comparison.
Lydia Kibet is a freelance writer with a knack for personal finance, investing, and all things money. She's passionate about explaining complex topics in easy-to-understand language. Her work has appeared in Business Insider, Investopedia, The Motley Fool, and GoBankingRates. She currently writes about personal finance, insurance, banking, real estate, mortgages, credit cards, loans, and more. Connect with her atlydiakibet.comorLinkedIn.
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